182. Action Memorandum From the Assistant Secretary of State for
Economic and Business Affairs (Katz) to the Under Secretary of State for Economic
Affairs (Cooper)1

Washington, January 15, 1979.

U.S. Oil Strategy Toward Saudi Arabia

Issue

The uncertain conditions in the world oil market, as a result of the
cessation of Iranian oil exports, emphasize the need to update our
strategy to encourage Saudi Arabia to continue to meet the world’s
essential energy needs.

—to convince Saudi Arabia to continue to produce all the oil it can to
help offset the shortfall owing to the Iranian situation.

Over the longer term, we seek:

—to obtain a Saudi decision to expand production capacity more rapidly;
and

—to produce conditions propitious for a freeze of OPEC oil prices in 1980.

Background and Analysis

The strikes in Iran’s oil sector, which began to interrupt oil exports in
late October, led other OPEC
nations—particularly Saudi Arabia—to produce higher than normal levels
of oil in November and December. Tight oil market conditions and
uncertainty over the likely course of events in Iran were important
factors behind the Saudis’ failure to press OPEC members to decide upon a lesser price increase at the
December 16 meeting.2

In normal circumstances, the world oil industry adjusts to seasonal
demand by building stocks during the second and third quarters of the
calendar year, and drawing down stocks during the first quarter and part
of the fourth. Since late December, the cessation of Iranian oil exports
has withdrawn about 5.5 million barrels per day (mmb/d) from normal oil
supplies. Saudi Arabian production has increased to about 10.5 mmb/d, or
2 mmb/d more than would have been anticipated at this time. Other OPEC members—primarily Kuwait and
Iraq—have also increased oil output, and there is ample economic
incentive for other oil producers to maximize output. We estimate that
an additional 1 mmb/d is being supplied to the world oil market by
producers other than Saudi Arabia. The remaining “shortfall” of somewhat
over 2 mmb/d is being met by drawing down stocks. World oil stocks were
very high late last year, partly as a result of seasonal stockbuilding
and partly owing to anticipatory purchases in advance of the expected
OPEC price increase.

With restoration of at least half of Iran’s normal exports within the
next few months and continued additional output by other producers, oil
market conditions will be manageable, though tight for the rest of the
year. Unless conditions improve more rapidly than now seems likely,
however, it would be futile to attempt to roll back any portion of
OPEC’s announced quarterly price
hikes. A more feasible objective would be to ensure that sufficient oil
will be available to meet normal [Page 585]demand, avoid hoarding, reduce the chance for market-induced price
increases in the remainder of this year, and set the stage for a price
freeze in 1980.

In the immediate future, there is a danger that Saudi output ceilings or
other restrictions could reduce incremental oil output needed to help
offset the shortfall in Iranian exports. Since mid-1977, Saudi Arabia
has maintained a ceiling of 8.5 million barrels per day, calculated as
an annual average. Until the Iranian crisis, oil market demand never
tested this ceiling. The Saudis have publicly acknowledged an obligation
to meet the world’s essential oil needs and since the cutback in Iranian
exports have permitted Aramco to
produce at maximum sustainable levels.

A Saudi official recently warned Aramco, however, that Saudi Arabia is considering
application of the ceiling on a quarterly basis. Aramco responded that this would impede
its normal adjustments of output to meet seasonal demand, as well as
interfere with the current all-out level in response to the Iranian
cessation of exports. A series of exchanges was inconclusive, though it
ended with an acknowledgement by a senior Saudi official that Aramco for the present could continue
as before. Moreover, Deputy Petroleum Minister Khayyal, in a
conversation with our personnel in Dhahran, clearly implied that Saudi
Arabia would, at least in the near future, continue to produce over 8.5
mmb/d in order to help meet the Iranian shortfall without referring to
the ceiling.3

Even when Iran’s production is restored in large measure, it will be
necessary for higher than normal liftings from Saudi Arabia to continue.
Strict application of the Saudi ceiling could interfere with the
satisfaction of deferred demand and normal second and third quarter
rebuilding of stocks by the oil industry.

Because the Saudi output ceiling has in the past served as evidence of
their willingness to restrain production in order to maintain OPEC prices, we should not expect them to
abandon the ceiling publicly or permanently. To do so might provoke
cutbacks in production by other OPEC
members now helping to offset the Iranian shortfall, especially if they
suspected the Saudi action was a prelude to an attempt to freeze oil
prices next year. Thus our approaches should be made privately, and we
should not make any reference to the price issue while we urge [Page 586]continued maximum production in
response to the shortfall in Iranian oil.

The current Iranian situation has driven home the dangers of a world oil
market with only 5 percent spare capacity. While Saudi production
capacity is adequate for foreseeable world demand over the next few
years, present Saudi conservation and investment policies prevent the
expansion of that capacity which will be necessary to meet unexpected
contingencies as well as essential world needs in the mid and late
1980s. We must plan to discuss with some intensity with the Saudis the
need for increased investment in production capacity, keeping in mind
the danger that a premature approach might detract from our efforts to
encourage the continuation of maximum Saudi production for a sustained
period.

Tactics

Our immediate goal is to obtain continued maximum Saudi output to offset
the Iranian shortfall, stressing that this need does not end when
Iranian exports resume, but will continue for a further time in order to
enable the oil industry to replace abnormal stock drawdowns and resume
normal stock rebuilding. The attached cable4 instructs Ambassador West to encourage such a Saudi
response. The President was advised to suggest that the Guadeloupe
summit5 countries also approach
the Saudis in this regard. It would be useful if you could inform their
Finance Ministers that we will be making our approach shortly.

The next step is to impress upon the Saudis, particularly in light of the
fragility of the market balance revealed by the events in Iran, the need
to approve additional plans to expand production capacity, both to
maintain their own influence within OPEC and to be able to meet increased world oil demand
expected in the next few years. This step should be taken by West in a low-key way. It may be
desirable thereafter to reiterate it in a more direct way and at a high
level, either by the President if Crown Prince Fahd visits the U.S.
soon, or by Secretary Schlesinger if he undertakes a trip to Saudi Arabia
later this spring.

If we are successful in obtaining Saudi agreement to high production
levels throughout the current year in response to the Iranian situation,
and if they agree to commence investment in expanded production
capacity, this may set the stage for pressing for an OPEC price freeze throughout 1980.
Specific presentations on the price issue should be withheld until later
in the year unless conditions change markedly.

According to telegram 21697 to
Riyadh, January 26, Aramco
sources informed the Department that Saudi Arabia formally notified
the company that the 8.5 million barrels per day production ceiling
would be raised to 9.5 million for the first quarter and would be
applied on a monthly basis. (National Archives, RG 59, Central Foreign Policy Files,
P850027–2555)↩